A Standard of Care for Lenders

December 18, 2007

Last week the WSJ published a great article about vulnerable California borrowers who’d been taken advantage of by a shady lender. A similar story in the NYT a month ago described how Countrywide deliberately steers borrowers into “high cost…unfavorable” loans in order to maximize their own profits. These stories are variations on the same theme: informed lenders taking advantage of uninformed borrowers. Yet they don’t tell the whole story. Borrowers share blame for taking on mortgages they couldn’t afford in the first place.

In the subprime age, mortgages are dangerously risky, potentially ruinous financial arrangements. And borrowers need to be protected not only from unscrupulous lenders, they need to be protected from themselves. Why can’t we hold mortgage lenders to the Prudent Man Rule or some other legal standard of care?

Today the Fed stepped in, using its authority under the Home Ownership and Equity Protection Act, to prohibit “deceptive” or “unfair” lending practices. First of all, this new regulatory regime is laughably tardy. Lenders have already stopped making subprime loans or gone out of business entirely. There’s no industry left to regulate.

But let’s imagine the Fed had issued this guidance in a more timely manner, say in 2004. What’s the point? Not only to prevent lenders from taking advantage of borrowers, but to prevent lenders from ENABLING borrowers. No stated income loans. That’s great. It prevents lenders from putting borrowers into loans they have no expectation of paying back in the first place.

But these regulations seem like a half measure. If lenders hadn’t been able to sell stated income loans, they’d have found other “innovative” ways to extend credit to the most unworthy borrowers. Why not take this regulatory effort a step farther and impose some legal standard of care on lenders? Make lenders liable if they knowingly put borrowers into less favorable—i.e. more profitable—loans.

Arguments against legal standards of care like “fiduciary duty” seem to me to be the following:

1. It will be a class-action bonanza.
2. It will reduce the availability of credit.
3. Most buyer/seller relationships aren’t regulated with any legal standard of care. It’s up to the borrower to make an informed purchase.

Taking those arguments in turn:

1. I don’t like the tort bar very much myself. Lawyers typically aren’t protecting consumers, they’re lining their own pockets. But I have to believe that the threat of class action lawsuits would act as a deterrent against flagrantly crooked lending practices.

Of course, rather than stopping crooked lending practices, it might just make legal fees a new cost of doing business, which would be passed on in higher interest rates to borrowers.  But the silver-lining of higher interest rates is that it hampers credit expansion.  And contrary to popular opinion, less credit is precisely what we need to repair the economy.

2. Marginal borrowers who were enabled by cheap credit to buy more house than they could afford shouldn’t have gotten credit in the first place. If new regulations reduce the availability of credit, preventing those who shouldn’t own a home from buying one, that strikes me as a good thing.

3. We’re not talking about a $20,000 car loan here. We’re talking about a $300,000 home loan. Not only is a mortgage a huge financial commitment, it’s also, perhaps, the most complex financial arrangement most Americans will ever enter into. The late Fed Governor Edward Gramlich said it best when he wondered why the most complex mortgage loans were being sold to the least sophisticated borrowers. Why? B/c they don’t know they’re being taken to the cleaners.

All this business that we don’t want to regulate Wall Street in a way that inhibits “financial innovation” strikes me as so much hogwash. When was the last time an investment banker added value to ANY financial transaction? Bankers don’t innovate, they expropriate.

I’m overstating my case a bit of course. Like equity capital, availability of credit is a crucial financial lubricant that drives economic development. Making credit widely available is a key to sustainable economic growth. Yet, credit can be as dangerous as it is important. It needs to be handled prudently, both by lenders and by borrowers.

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